What kind of IRA is right for me?

Q. I just started my first job post-residency and have finally received my first “real” paycheck. My friends tell me I should start an IRA or a Roth right away, but they are not physicians. What kind of IRA (if any) would be appropriate for someone in my situation?

A. Outside of employer-sponsored retirement plans, such as the 401(k), individual retirement arrangement (IRAs) can be an excellent way to enhance your tax deferred savings for retirement. While traditional IRAs (henceforth referred to just as IRAs) have been around for a long time, about a decade ago Congress gave us the Roth, named after the senator who spearheaded its existence. The media has touted the Roth IRA as better than the IRA for high income earners, but as you’ll see, it’s not quite that simple.

The Traditional IRA

The basics: This pre-tax investment vehicle allows you to defer a certain amount of money each year and deduct that amount from your income tax return for the year.

Age requirements: You must be less than 70.5 years old. Obviously, the earlier you start the better.

Salary requirement: If you take part in an employer-sponsored retirement plan there are income limits for participation in an IRA. In order to obtain the full amount of the deduction in 2009 ($5,000), your income must be less than $166,000, assuming you are married. If you do not participate in an employer-sponsored retirement plan then you can deduct the full $5,000 regardless of your income. To be eligible for an IRA, you must also have active income (salary, self-employment income, etc…).

Upside: One of the main reasons to use a traditional IRA is for cash flow. Let’s say that you are able to deduct the full $5,000 from your income tax return this year. If you are married and in the 28% federal income tax bracket, you will save $1,400 in federal income taxes. Even if your income exceeds the limits and you are not able to make a tax deductible contribution, you can still make a nondeductible contribution, allowing you to defer income tax on the earnings.

Downside: While it’s great to defer tax, it won’t last forever. You will be required to start taking distributions (known as required minimum distributions or RMDs) after age 70.5, and you will be taxed on 100% of the distributions at your highest tax bracket at the time. In other words, you will be taxed on all of your contributions and earnings upon withdrawal. Further, if you fail to take RMDs, you must pay a hefty 50% penalty on the shortfall. Also, if you remove money from an IRA before age 59.5, you may be faced with a 10% penalty in addition to paying income tax on the withdrawal.

Notes: Generally it’s preferable to participate in your employer sponsored plan (401k, SEP IRA, etc) first before contributing to an IRA because the amount of tax deferral is much higher in employer sponsored plans. In 2009, for example, you can defer $16,500 of your salary to a 401(k) but only $5,000 to an IRA. The advantage of the IRA over the 401(k) relates to the wide choice of investment options versus the limited choices typically seen in 401(k) plans.

Example: Assume that a physician contributes $5,000 to an IRA every year starting at age 30 and ending at age 65. Assuming an annual investment return of 8% and a preretirement and postretirement tax bracket of 25%, by age 65 his account has grown to over $861,000. Unfortunately, the entire value will be taxed at 25%, so that the after tax value of the account is really about $645,000.

The Roth IRA

The basics: This after-tax retirement vehicle allows you to contribute a certain amount of money each year and never pay tax on it or any of its earnings ever again.

Age requirement: None

Salary Requirement: Like the IRA, for a married taxpayer you must have active income in order to make a contribution, and your income must be less than $166,000 in order to make the maximum contribution ($5,000). Unlike an IRA, you can participate in an employer sponsored retirement plan without affecting your eligibility for a Roth IRA.

Upside: You will never pay tax on your contributions or your earnings upon withdrawal regardless of your income tax bracket during retirement. Also, you are not required to take RMDs ever with the Roth IRA. This feature provides a great way for you to leave a significant inheritance to your children. Withdrawals of contributions from a Roth IRA are never taxed nor is there a 10% penalty (though you may be taxed and penalized on the earnings). With this feature, the Roth IRA can potentially serve as an emergency fund of last resort.

Downside: You will pay tax now on your contribution at your highest tax bracket. In order to contribute the $5,000 maximum, you must actually set aside $6,944 assuming a 28% tax bracket. This may create a cash flow problem for you, plus psychologically you may not feel comfortable with paying taxes now.

Example: By contributing $5,000 every year to a Roth IRA and making the same assumptions as the previous example, by age 65 the account has also grown to over $861,000, but none of it is taxed upon withdrawal so you own the entire amount. Essentially, the Roth IRA allows you to contribute more money to the account than the IRA because out of the $5,000 contributed to the IRA, you only own $3,750 due to taxes.

And the winner is . . .
With all the bells and whistles in a Roth IRA, why would any physician contribute to a traditional IRA over a Roth? Let’s take a look:

In the above examples, it looks like the Roth IRA is the clear winner, but that conclusion is a mistake. It is only true because you can contribute more of an after-tax amount to a Roth IRA than an IRA. Contributing $5,000 to an IRA is the same as setting aside $5,000, paying the tax, and then investing the after tax value in a Roth IRA. By equating after tax values, there is no difference in account values at retirement between an IRA and a Roth IRA.

The difference between the traditional and Roth IRA, therefore, lies in the difference between the preretirement and postretirement tax rates. If your postretirement tax rate is higher than your preretirement tax rate, then it makes more sense to invest in a Roth IRA. Conversely, if your postretirement tax rate is lower than your preretirement tax rate, then the traditional IRA wins. The problem then becomes predicting future tax rates. While most financial planners think it’s inevitable for tax rates to increase in the future, the amount of the increase and an individual taxpayer’s exposure to those rates is uncertain. The highest tax bracket over the past century has fluctuated wildly, with the highest rate at one time being 90%! One common misconception here is to assume that as a physician your income tax bracket at retirement will be higher than it is right now, leading to the conclusion that the Roth IRA is the way to go. Your tax rate at retirement depends on numerous variables, including your savings rate, your years to retirement, your investment returns, your part time income, your Social Security benefits, your RMDs, and others. Given this uncertainty it probably makes sense for most physicians to split contributions between the traditional and Roth IRAs in order to hedge against rising or falling tax rates.

Setu Mazumdar M.D. practices emergency medicine in Atlanta, GA and is a member of the National Association of Personal Financial Advisors (NAPFA).